The Risky Mortgage Business: The Problem with the 30-Year Fixed-Rate Mortgage

One would not be troubled by the 30-year fixed-rate mortgage if it were an emergent property of free markets. But it is not.

Editor’s note: this is part three in a series of essays about housing policy.

The United States is unusual in that the standard mortgage product has a fixed interest rate for 30 years, with prepayment allowed at any time with no penalty. This structure creates many opportunities for the borrower to gain at the lender’s expense.

The firms that supply funds for this mortgage product are faced with a choice. Either they must find a way to offload risk, ultimately to the taxpayers, or they must charge a sufficiently high interest rate so that, on average, the profits in a relatively stable interest-rate environment offset the losses that are incurred when rates go through periods of volatility.

Policymakers should be concerned about the risk borne by taxpayers. One would not be troubled by the 30-year fixed-rate mortgage if it were an emergent property of free markets.

Another important characteristic of the standard mortgage is that it is a level-payment, amortizing mortgage. That is, the borrower pays the same amount each month, and this amount is sufficient to pay off the principal at the end of the 30-year period. This level-payment feature helps to reduce the risk of borrower default, although in a high-inflation environment, it poses affordability problems for new home buyers.

In the early years of the mortgage, much of the borrower’s monthly payment is for interest. Most of the paydown of principal kicks in during the latter years of the mortgage. In fact, under most circumstances, the majority of the equity that home buyers accumulate comes from increases in home prices. When house prices have been rising for several years at the same pace as general inflation, or faster, then owners earn decent returns on their investment. They often become “trade-up” buyers, selling their homes and putting the profits into buying larger homes. On the other hand, if house prices rise much more slowly than the general rate of inflation, then home owners are unlikely to accumulate more wealth than they would have by renting while investing their savings in other assets.

For home buyers, it may be comforting to know that if they stay in their homes and do not take out another mortgage, then over the next 30 years their mortgage payment cannot go up. However, in the financial markets, there are few, if any, natural lenders for a 30-year term.

Financial institutions are safest when the characteristics of their assets match the characteristics of their obligations. For example, if a company is in the business of selling 10-year fixed annuities, then backing those annuities with 10-year fixed-rate assets makes sense.

One problem for the 30-year fixed-rate mortgage is that there are hardly any potential ultimate lenders with a financial outlook that fixes their obligations for 30 years. Most investors have no natural desire to hold 30-year fixed-rate mortgages to maturity. Instead, they invest in mortgages to earn a return for a few months or years, treating the additional years of payments as a sort of “residual.” An institution might buy a mortgage-backed security, intending to keep it for five years. After that, perhaps the institution will hold onto the security and collect the remaining payments, or perhaps it will sell the security.

In the financial market, mortgage assets compete with other assets of similar financial duration. The financial duration of a mortgage is much less than 30 years. Duration is shortened by monthly payments, by prepayments that take place when houses are sold, and by refinancing. The calculation is far too complicated to be explained here. However, the duration of a new mortgage might typically be estimated at between seven and eight years.

If house prices rise much more slowly than the general rate of inflation, then home owners are unlikely to accumulate more wealth than they would have by renting while investing their savings in other assets.

Mortgage pricing also is affected by the prepayment option. If you invest in mortgages, you are likely to have all your principal returned early when you least want it — after a drop in interest rates. When interest rates fall, prepayment rates soar, and you have to reinvest the principal at a new, lower interest rate. If interest rates had gone up, then you would be happy to have your principal back, so that you could reinvest it at a higher interest rate. However, when interest rates go up, prepayments slow down, as borrowers hang on to their mortgages longer.

Consider a hypothetical example. Suppose that a large mortgage lender, like Freddie Mac, issues a seven-year bond at an interest rate of 3 percent to fund a portfolio of mortgages with an interest rate of 4 percent. If interest rates remain steady, Freddie would earn a spread of 1 percent per year. However, if all interest rates next year rise by 2 percent and remain elevated, then many borrowers will keep their loans well past seven years, so that when the seven-year bond expires Freddie Mac will have to issue a new bond at 5 percent, while the mortgage portfolio continues to earn just 4 percent. From that point on, the spread is negative.

Alternatively, if all interest rates next year fall by 2 percent, then the mortgages in the portfolio will swiftly be prepaid, and Freddie Mac will have to reinvest the proceeds at, say, 2 percent, while continuing to have to pay 3 percent interest on its bond. In this scenario, also, Freddie would suffer from a negative spread.

To put this another way, the duration of a mortgage changes with market conditions, and it does so in a way that is adverse to the lender. A brand new mortgage, at an interest rate of, say, 4 percent, might have a duration of seven years when first issued. If market interest rates rise, its duration will lengthen, as prepayments slow down. If interest rates fall, its duration will shorten, as borrowers rush to refinance at lower rates.

What this means for lenders is that in order to stay away from the risk of duration mismatch, they must constantly rebalance their portfolios in response to movements in interest rates. That is why interest-rate options and other derivatives tend to emerge in mortgage finance. A lender can achieve more robust duration match by, for example, issuing callable debt, which is debt that can be repaid early if interest rates fall. Other tools that are used in practice include interest-rate options, swaps, and many more-esoteric derivatives.

However, although any one institution can use sophisticated financial instruments to transfer away the interest-rate risk embedded in mortgages, that risk does not disappear. It ends up somewhere else. Because government officials are loathe to see important financial institutions fail, “somewhere else” all too often ends up being in the hands of the taxpayers.

Interest-rate risk migrates toward those financial institutions that enjoy the highest level of perceived government protection with the least effective form of regulation. The perceived government protection enables them to serve as reliable counterparties to households and firms seeking risk protection. The relatively less stringent regulation leads the risk-bearing institutions to reap gains when interest rates are relatively stable, without having to hold sufficient capital to survive a major shock.

In the three decades after World War II, it was the Savings and Loan industry that enjoyed the most protection with the least effective regulation. Accordingly, the S&Ls loaded up on interest-rate risk. They issued 30-year mortgages funded by deposits that could be liquidated in an instant. The joke was that managing an S&L was a simple 3-6-3 job: pay savers a rate of 3 percent on deposits, charge borrowers 6 percent for mortgage loans, and go to the golf course at 3 p.m. As long as short-term interest rates stayed below 6 percent, that worked fine. However, in the late 1970s, rates rose above 10 percent, and paying 10 percent on liabilities while earning 6 percent on assets was a big negative spread.

When interest rates fall, prepayment rates soar, and you have to reinvest the principal at a new, lower interest rate.

By the late 1980s, the S&L industry was decimated. Moreover, in reaction to the S&L fiasco (having cost the taxpayers over $100 billion, which at the time was a huge expense), regulators of banks and S&Ls tightened up capital and accounting requirements for interest-rate risk. Soon, it was Freddie Mac and Fannie Mae who faced the least onerous regulation of interest-rate risk while still enjoying government backing. Fannie Mae, which had suffered losses on its mortgage portfolio in 1979-1981 just as had the S&Ls, managed to grow its way out of trouble, helped by the decline in interest rates that took place in the mid-1980s. Freddie Mac, which avoided interest-rate risk in the early 1980s by selling all of its mortgage loans to investors as securities, discovered by the early 1990s that its most profitable strategy was to follow Fannie Mae into the business of retaining mortgage securities in its portfolio while taking on and attempting to manage interest-rate risk.

As of the present time, much of the interest-rate risk on mortgages is being borne by Freddie and Fannie, which have almost no layer of capital to protect taxpayers. Another significant risk bearer is the Federal Reserve, which has a large portfolio of mortgage securities.

If interest rates were to rise sharply over the next few years, this could lead to operating losses at Freddie, Fannie, and the Fed. Those losses would have to be funded by taxpayers. (Technically, the Fed could fund its losses by crediting banks with new reserves, which is the way that it expands the money supply. However, such a monetary expansion most likely would conflict with its macroeconomic policy objectives. It is doubtful that the Fed would view this as a desirable option.)

How could regulators keep interest-rate risk in private hands and protect taxpayers? In order to do so, they would have to identify all of the institutions in the interest-rate risk management “supply chain” and impose sufficiently stringent capital requirements upon them to ensure that risk is borne by private investors. For example, if certain regulators get their wish and financial derivatives are traded on a central exchange, then the regulators will have to monitor every seller of options in these derivatives markets to ensure that they are sufficiently capitalized (of course, the exchange, too, will have an incentive to monitor capital positions).

Suppose that regulators actually succeed in locating all of the bearers of interest-rate risk and holding them to strict capital standards. I believe that the consequence of this will be that the interest rate on 30-year fixed-rate mortgages will rise significantly relative to mortgage instruments where rates are fixed for a shorter period.

What might happen in the mortgage market as a result? There are mortgage instruments, such as adjustable-rate mortgages with monthly interest-rate changes, that go too far in the direction of putting borrowers at risk. However, there are other instruments, such as the five-year rollover mortgage popular in Canada, that represent a balanced approach. I would much rather see the United States import the Canadian mortgage system than put the burden on taxpayers to save the 30-year fixed-rate mortgage.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for econlog, part of the Library of Economics and Liberty.